International Money and Capital Markets - Research Paper Example

International Money and Capital Markets Part I Determinants of movement in the exchange rate The in the article has recognized four main factors that had a strong influence on the movement of exchange rate, namely, difference in economic growth profile among countries, relative price level, trade flow among countries and prevailing interest rate. One of the important aspects of an economy that highlights its growth prospect in context of international business is gross national product or gross national income. Unlike Gross Domestic Product, GNP takes in consideration foreign trade activities. A developed economy is defined by high level of economic activities including foreign trade resulting to high demand of foreign currency, especially hard currencies such as US dollar. A higher demand of foreign currency induces increase in exchange rate and the other way round (Taylor, 2001). Exchange rate shares an important relationship to relative price level because; price level establishes a link between foreign price and domestic price. Relative price difference or purchasing power parity is an important determinant of exchange rate as it recognizes various adjustments that need to be made in the exchange rate for maintaining equilibrium in the international currency rates (Auboin and Ruta, 2013). Trade flow can be categorized as trade inflow (import) and trade outflow (export). When the cost of foreign currency is relatively high, countries focus on greater export and less import while low exchange rate result in increasing level of import. However, frequent fluctuation in the exchange rate has negative impact on trade flow because of fluctuation in transaction and conversion costs (Auboin and Ruta, 2013). Interest rate is an influential factor with respect to fluctuation in exchange rate. Studies suggest that higher interest rate result in appreciation in the currency value of a country with respect to that of other because, high interest rate attracts greater investment in the appreciating currency for earning better future returns (Taylor, 2001). Impact of economic factors on exchange rate equilibrium Assessment of exchange rate behavior is a perennial subject of international monetary economics where various macroeconomic factors are examined to understand their role in maintaining equilibrium in exchange rate. Exchange rate equilibrium is established when quantity of product and/or service supplied in one currency is equal to the quantity supplied in another currency. However, exchange rate equilibrium is highly relative in nature as it heavily depends on international trade, capital movement, inflation rate, market uncertainty and political and regulatory factors (Harberger, 2003; UNCTAD, 2013). Equilibrium in exchange rate can be established when a balance is developed among all the above mentioned factors. For instance, international trade stabilizes currency exchange rate when import and export in the current account of a country is balanced even if in terms of different commodities. Capital movement in terms of foreign investment plays an important role in determination of equilibrium as excess capital outflow weakens the domestic currency and creates an imbalance. Inflation has a strong impact on export and import as well as demand for domestic currency. High inflation and deflation affect exchange rate equilibrium adversely as it triggers unexpected fluctuations. Market uncertainty and political and regulatory frameworks are major determinants of strength of an economy. A stable market and political environment tend to stabilize exchange rate movement through smooth trade and capital flow. On the contrary, market uncertainty, political disturbance and stringent policies hinder market flexibility and affect investors’ confidence negatively (Harberger, 2003; UNCTAD, 2013). Definition of current account and impact of exchange rate on current account The current account is an essential component of the balance of payment. In the international finance, balance of payment is defined as a record of all international monetary transactions of a country for a specific period of time, generally a year. All these transactions are further classified in current account and capital account. The current account reports transactions in terms of import and export of goods and services in an economy with other economies in the world. The current account focuses on net exchange of goods, net exchange of services and net transfer. The current account highlights the pattern of foreign trade in terms of deficit or surplus. Theoretically, current account balance should be zero for ensuring exchange equilibrium (Dornbusch and Fischer, 1980). Studies suggest that depreciation in value of domestic currency causes appreciation in the current account surplus. The reason is that, when value of domestic currency declines, the value of export in term of foreign currency with respect to the domestic currency increases proportionally. On the other hand, when value of domestic currency is higher than relative value of foreign currency, higher import is undertaken so that capital outflow in terms of purchase is less. However, it is noteworthy that minor fluctuations in exchange rate do not have direct impact on current account because import and export are necessary for overall economic development (Dornbusch and Fischer, 1980). Impact of strong position of dollar on inflation For understanding role of strong dollar in checking inflation, it is important to analyze relationship between flow of currency and inflation. Inflation is a situation that is created when level of liquidity in an economy depletes resulting to sudden rise in cost of goods and services. Inflation, in context of foreign trade, is triggered when either the cost of imported goods is sold at a comparatively high price or the export cause shortage of commodities in the domestic market. Overall, a high inflation suggests that the domestic currency is losing its value in context of other foreign currencies. It has already been discussed that when domestic currency strengthens, import is increased. Therefore, a strong dollar value will induce high import and low export. As dollar strengthens against other currencies, the country pays fewer dollars for imported products. Consequently, import increases and the increased inflow of commodities result in drop in price per unit of a commodity. Inflationary situation develops when demand is relatively higher than supply but as supply increases and demand is met at competitive price, inflation declines (Parliament of Canada, 2003). Part II After assessing the given article, it was ascertained that the authors tried to establish certain relationship between euro zone and the US treasury yield. US bond yield not only have an impact on Euro zone but also on the overall financial market. It is important to understand the US monetary policy as well as the ECB (European Central Bank) monetary policy so that the underlying issues related to US bonds are uncovered. Monetary policy of the US Till 2008, the Federal Reserve of the US followed the conventional monetary policy that was driven by three instruments, namely, open market operations, discount rate and the reserve requirements. The open market operations have been the key instrument of the Federal Reserve which comprises purchasing and selling of financial instruments. These financial instruments are generally securities that are issued by the US Treasure and other government sponsored agencies. The bank buys securities when an increase in reserve is necessary and other way round. The securities trading have a significant impact on the bank reserves which in turn affect federal fund rate (the interbank lending or borrowing rate for reserves). The federal funds rate is affected by demand and supply of reserves; thereby acts as an effective indicator of liquidity in the economy (William, 2012). The discount rate denotes the interest rate that other banks need to pay the Federal Reserve for short term borrowings. The discount rate is closely related to the federal funds rate but is generally lower than the same. The reserve requirements comprise a certain amount of total deposits of banks which they need to maintain either in the bank’s vault or as deposit with the Federal Reserve. However, these instruments of US monetary policy were unsuccessful in controlling the global recession and financial crisis of 2008. It was ascertained that during this period, the real gross domestic product of the country declined sharply while unemployment soared at an exponential rate resulting to creation of a free fall economy (William, 2012). The monetary policy body of Federal Reserve, the Federal Open Market Committee (FOMC) had to reduce the federal funds rate to zero for combating the situation. The main idea of the conventional monetary policy was that a drop in federal funds rate will cause decline in other interest rates as well and boost the stock market. However, the dire straits of the US economy demanded the federal funds rate to be lower than zero which was an impossible condition. Therefore, two unconventional tools were proposed as alternatives, namely, forward policy guidance and quantitative easing or large scale asset purchases (LSAPs) (William, 2012). The idea of forward guidance was initially introduced by Krugman as he assessed issues related to deflation and liquidity trap in Japan in 1990s. Forward guidance was a statement released by the FOMC that addressed the households, investors and businesses regarding the current economic condition, risks, the expected future situation and steps that will be taken by the Federal Reserve. The aim was to disseminate a clear message to the public so that market disruption and asset price fluctuations are minimized that are caused by surprises and panics (Claeys, 2014). The second instrument that was adopted by the Federal Reserve was quantitative easing with an aim to lower down long term interest rate and boost economic activities. It is important to note that LSAPs are of no use when the financial markets are perfect but it worked for the US economy and reinforced the forward guidance because perfect financial market is only possible in theories as suggested by Tobin and Modigliani. Between 2009 and 2014, the Federal Reserve purchased about $1.9 trillion worth long term US treasury bonds and $1.6 trillion worth mortgage backed securities along with other short term liquidity measures. The policy resulted in increase in the GDP in context of the baseline by 3% and that in inflation by 1%. In 2013, the Federal Reserve announced tapering of LSAPs. By tapering, it is implied that the bank reduced its monthly purchases from $85billion to $35billion (Claeys, 2014). ECB monetary policy Since the financial crisis of 2008, unlike Federal Reserve of the US and Bank of England, ECB continued to follow its traditional monetary policy so as to ensure that liquidity is maintained in the banking sector and lending channels are repaired so that credit supply is revived in the euro zone. The ECB introduced significant number of policies for increasing credit support in the economy. These measures reduced the overall policy rate from 4.25% to 1% between 2008 and 2009 and to 0.15% between 2011 and 2014. ECB primarily allocated liquidity through Long Term Refinancing Operations (LTRO) and Main Refinancing Operations (MRO) where banks were allowed to have unlimited access to liquidity of the central bank depending upon adequate collateral. It was also observed that the maturity of LTROs was extended from 3 months to 1 year over the time. Alongside, two very long term refinancing operations (VLTROs) were implemented that had a maturity of 3 years. As ECB made banks repay the borrowed fund under LTRO prior to maturity, the frontloaded reimbursements caused severe decline in liquidity which by beginning of 2014 was completely reabsorbed (Claeys, 2014). In 2010, the ECB introduced Securities market Programmed, where it bought government bonds of various EU based nations. This programmed had a short term impact of market activities as it temporarily minimized the volatility related to bond yields. This programmed was replaced by Outright Monetary Transactions in 2012. Under this programmed, the ECB was allowed to buy unlimited quantity of government bonds. This programmed had a significant impact on the bond yields in Europe. In 2013, the ECB introduced forward guidance as an important monetary policy tool. The primary aim of introducing this policy was to lower short term rates and increase expectation of investors regarding inflation. It was also ascertained that it will have a negative impact on long term rates and thereby will boost consumption and investment. However, the impact of forward guidance declined in the Euro Zone when the ECB clarified to investors and the public that it is not making any kind of commitment through the guidance regarding lowering of rates, instead it is just a method of communicating the bank’s strategies. It is also worth mentioning that unlike the US and Bank of England, the ECB did not adopt LSAPs or quantitative easing for mitigating issues related to liquidity crunch and deflation (Claeys, 2014). Deflation in Euro zone Deflation is defined as decline in price as a consequence of reduction in credit or money supply in the economy. The situation is also created from heavy decline in personal and government spending. Deflation has a negative impact on economy in terms of high level of unemployment, low level of demand and declining purchasing power. High level of deflation often takes shape of deflationary spiral and long term economic depression (Polak, 2014). The scope of deflation is considered to be strong in euro zone because, the recovery of the overall economy is comparatively weak while its financial market is highly fragmented. It was further determined that there is a liquidity crunch prevailing in the economy. Deflation is considered appalling because of two factors, namely, negative impact on purchasing power and increasing expensiveness of debt payments. In Euro zone, nations such as Greece and Italy are already in heavy debt and deflationary trend has been observed in countries such as Spain, Portugal and Greece. Additionally, in Southern Europe the situation has worsened due rampant unemployment and reluctance of consumers to spend (The Economist, 2014a). Impact of Euro zone deflation on US growth European deflation is a concerning factor not only for the EU economies but also an economic nightmare for the world economy. Stagnation in the European economy is a concern for majority of nations across the globe because most of Euro zone debt is owned by countries outside EU and it is highly vulnerable to regional conflicts which may further have negative impact on the economy (The Guardian, 2014). It was gathered that uncertainty regarding future prospects of Euro currency has an indirect dampening effect on economic growth in the US and further worsening of the situation will act as a huge blow to the recovery of the US economy. Studies suggest that the US exports account for about 19 percent of total export in European Union while the Euro zone itself accounts for at least 13 percent. Therefore, the deflation will act as a direct blow to the trade relationship between European economy and the US economy. Additionally, Europe holds about 25 percent of world trade and is a major trading partner of the US and China. Consequently, deflation in Europe will affect US growth as well as world economy through decline in trade and consumer confidence (Reuters, 2012). Quantitative easing as an option for ECB It is important to gather background information on quantitative easing prior discussing its role in rescuing European economy from deflation. Central bank is considered the highest monetary regulatory body of a country. Essentially, it is responsible for maintaining a balance between inflation and deflation in the economy. As the crisis of 2008 struck, major central banks such as Federal Reserve and Bank of England had to cut back the interbank lending rate almost to zero for triggering economic recovery but they failed. Consequently, an unconventional tool of monetary policy was adopted known as quantitative easing (The Economist, 2014b). Quantitative easing is the process where the central bank of a nation induces liquidity in the economy through bulk buying of securities such as government bonds. QE lowers interest rate as the demand for securities increases and supply falls; alongside, it stimulates the economic growth by encouraging banks to create greater number of loans. The QE along with Forward Guidance plays an important role in convincing the investors and general public that the central bank is undertaking measures of combating deflation and unemployment, so that economic activities are boosted with rise of consumer confidence (The Economist, 2014b; Williams, 2012). The Euro zone economy is in an extreme fragile condition with little hope of rising inflation as countries such as Portugal and Greece are already in deflation. The ECB so far adopted different monetary tools to maintain liquidity in the banking sector with no significant outcome. It has been ascertained that QE or large scale asset purchase programmed is the last resort for reviving the economy and increasing the inflation level. The QE programmed has been successful to a certain extent for Bank of England and Federal Reserve in stimulating economic activities in the US and the UK. Given that other tools of monetary policy were unsuccessful for ECB and QE has a comparatively high success rate in various economies such as that of Japan, the US and the UK, this unconventional tool may proved useful for the Euro zone (The Economist, 2014b; The Wall Street Journal, 2014). Reference list Auboin, M. and Ruta, M., 2013. The relationship between exchange rates and international trade: a literature review. World Trade Review, 12(3), pp. 577-605. Claeys, G., 2014. The (not so) Unconventional Monetary Policy of the European Central Bank since 2008. [online] Available at: [Accessed 26 September 2014]. Dornbusch, R. and Fischer, S., 1980. Exchange rates and the current account. The American Economic Review, pp. 960-971. Harberger, A. C., 2003. Economic growth and the real exchange rate: revisiting the Balassa-Samuelson effect. [pdf] University of California. Available at: [Accessed 26 September 2014]. Parliament of Canada, 2003. The rising dollar: explanation and economic impacts. [online] Available at: [Accessed 26 September 2014]. Polak, P., 2014. The Next Japan: How Deflation Threatens The European Union. [online] Available at: [Accessed 26 September 2014]. Reuters, 2012. What would Greek exit mean for the U.S. economy? [online] Available at: [Accessed 27 September 2014]. Taylor, J. B., 2001. The role of the exchange rate in monetary-policy rules. American Economic Review, pp. 263-267. The Economist, 2014a. How serious is the risk of deflation in the euro zone?[online] Available at: [accessed 26 September 2014]. The Economist, 2014b. What is quantitative easing? [online] Available at: [accessed 27 September 2014]. The Guardian, 2014. Deflation would be the stuff of nightmares for European economies. [online] Available at: [accessed 27 September 2014]. The Wall Street Journal, 2014. ECBs Draghi Keeps Door Open to Quantitative Easing. [online] The Wall Street Journal. Available at: [Accessed 27 September 2014]. UNCTAD, 2013. Exchange rates, international trade and trade policies. [pdf] UNCTAD. Available at: [Accessed 26 September 2014]. Williams, J.C., 2012. The Federal Reserve’s Unconventional Policies. [online] Available at: [Accessed 26 September 2014]. Read More